Ebook corporate governance by monks

A CKNOWLEDGMENTSFirst and foremost, we want to thank Kit Bingham, former editor of the indispensable magazine Corporate Governance, without whom this book would still be just a dream.. I

CORPORATE GOVERNANCE

Corporate Governance

Robert A.G Monks and Nell Minow

The most comprehensive examination and commentary on corporate governance that I haveyet seen If I had to choose one book among the dozens available to explain and illumi-nate the complexities of corporate governance, this definitive treatise would be it

Hugh Parker Corporate Governance is a lucid and comprehensive introduction to a subject that is of critical

importance to anyone interested in business Everyone, from student, to scholar, to corporateemployee, officer, director, or shareholder, will find it valuable

Donald Jacobs, Dean, Kellogg School of Business, Northwestern University

This is what we’ve needed – a solid text on corporate governance written by two of the realstars in the field

D Jeanne Patterson, former Associate Professor of Public and Environmental Affairs, Indiana University

a fresh, thoughtful, and timely look at the problem of corporate governance a little gem

Joseph A Grundfest, Professor of Law, Stanford Law School

Exactly what’s needed for MBA students and management professionals

Gordon Clark, Dean, Faculty of Arts, Monash University

The MBA student seeking real world examples will be well satisfied with this material amajor strength of the book is the practitioner perspective that the authors bring to the area

Stuart L Gillan, The University of Texas at Austin

authoritative and informative, with some fascinating case vignettes A monumentalwork

Bob Tricker, Editor, Corporate Governance

carefully blends economic and legal aspects of corporate governance Highly recommended

for use in seminars on board practices, MBA programs, and corporate governance forums Cornelis

A de Kluyver, former Dean, School of Business Administration, George Mason University

Highly useful illuminates the current issues facing managers, boards of directors, and holders, as well as explaining their respective roles in the corporation

share-Ira M Millstein, Weil, Gotshal & Manges; Lester Crown Visiting Faculty Fellow, Yale School of Management

Provides a strong theoretical framework for the subject It gives meaning to the important lic policy issues by numerous examples, case studies, and policy statements

pub-Professor J Fred Weston, UCLA

(Praise for the first edition)

C ORPORATE G OVERNANCE

Third Edition

Robert A.G Monks

Nell Minow

© 2004 by Robert A.G Monks and Nell Minow

350 Main Street, Malden, MA 02148-5020, USA

108 Cowley Road, Oxford OX4 1JF, UK

550 Swanston Street, Carlton, Victoria 3053, Australia The right of Robert A.G Monks and Nell Minow to be identified as the Authors of this Work has been asserted in accordance with the UK Copyright, Designs, and Patents Act 1988.

All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs, and Patents Act 1988, without the prior permission of the publisher.

First published 1995 by Blackwell Publishing Ltd Second edition published 2001, reprinted 2002 (twice), 2003 (twice) Third edition published 2004

Library of Congress Cataloging-in-Publication Data

Monks, Robert A G., 1933–

Corporate governance / Robert A.G Monks and Nell Minow – 3rd ed.

p cm.

Includes bibliographical references and index.

ISBN 1–4051–1698–6 (pbk : alk paper)

1 Corporate governance – United States I Minow, Nell II Title.

To the future: Max, Mariah, and Megan

R.A.G.M.

To David, Benjamin, and Rachel

N.M.

Human capital: “It’s not what you own but what you know” 70

The Sleeping Giant Awakens: Shareholder Proxy Proposals on

Today’s Typical Board 197

The Biggest Challenge 258

Mondragón and Symmetry: Integration of Employees, Owners,

France 333

A Conformist Culture 497

Appendix: Overview of Corporate Governance Guidelines and Codes of Best Practice in Developing and Emerging Markets

Cases in Point

T Rowe Price and Texaco 132

Mondragón and “cooperative entrepreneurship” or “cooperation instead of

A CKNOWLEDGMENTS

First and foremost, we want to thank Kit Bingham, former editor of the indispensable

magazine Corporate Governance, without whom this book would still be just a dream His

tireless, thorough, creative, and even cheerful diligence provided most of the case studiesand supporting material, and he made even the more tedious aspects of research and writing a genuine pleasure Professor Emerita D Jeanne Patterson did a masterful job ofreading through hundreds of academic papers and assembling the material for the Enronsupplement Holly Gregory of Weil, Gotshal, and Manges LLP created the incomparable materials on corporate governance in emerging and established economies, and we areimmeasurably grateful to her for allowing us to share them with our readers

We are also very grateful to the heroic scholars whose work instructed and inspired us,especially Jonathan Charkham, Sir Adrian Cadbury, David Walker, Robert Clark, AlfredConard, Peter Drucker, Melvin Eisenberg, Shann Turnbull, Betty Krikorian, Margaret Blair,Jeffrey Sonnenfeld, Adolf Berle and Gardiner Means, and James Willard Hurst

We have also learned a great deal from our colleagues, clients, and friends, includingthe widely disparate group of institutional investors all joined together by their commit-ment to the beneficial owners they serve as fiduciaries and the corporate managers theymonitor as shareholders It also includes the corporate managers, lawyers, regulators, com-mentators, and individual shareholders who care enough about making things work better to make a difference These are also our heroes They include Kayla Gillan, LindaCrompton, Carol Bowie, Peter Clapman, Stephen Davis, Olena Berg, Tom Horton, Dale Hanson, Rich Koppes, Ned Regan, Tom Pandick, Harrison J Goldin, CarolO’Cleireacain, Patricia Lipton, Nancy Williams, Ned Johnson, Dean LeBaron, DickSchleffer, Janice Hester-Amey, Phil Lochner, the late Al Sommer, Cathy Dixon, MartinLipton, Ira Millstein and Holly Gregory, Luther Jones, Roland Machold, Michael Jacobs,the late John and Lewis Gilbert, Peg O’Hara, Mort Kleven, Alan Lebowitz, Karla Scherer,Kurt Schacht, Beth Young, Abbot Leban, Bill Steiner, Bob Massie, Tom Flanagan, BillMcEwen, David Greene, Alan Towers, Ann Yerger, Anne Simpson, Alyssa Machold, RogerRaber, Peter Gleason, Deborah Davidson, and Alan Kahn

We are also especially grateful to our dear friends Sarah A.B Teslik, Executive Director

of the Council of Institutional Investors, and Ralph Whitworth, of Relational Investors,who provided the leadership, support, and intellectual foundation for most of the develop-ments in this area over the past few years We have also learned a great deal from scholars,including Joe Grundfest, Charles Elson, Bernie Black, Mark Roe, and Jack Coffee John

M Nash and the late Jean Head Sisco, former Director and Chair of the National Association

of Corporate Directors, deserve special thanks for their labors in the field of governance

We are grateful to those who permitted us to use their material in this book, which addedinestimably to its value Thanks to Holly Gregory, Chancellor William Allen, Ira Millstein,Shann Tumbull (apologies for failing to provide an appropriate credit in the first edition), MartinLipton, Jay Lorsch, Cyrus F Freidheim, Hugh Parker, Oxford Analytica, Jeanne Patterson,Paul Hodgson, Aaron Brown, Joe Grundfest, Jamie Heard, Sophie L’Helias, Howard Sherman,Bruce Babcock, and Geoff Mazullo Dave Wakelin was most generous with his time in bring-ing us up to date on the Maine State Retirement System Cathy Dixon guided us throughthe thorny securities law issues with patience, good humor, and unbounded expertise BethYoung contributed the superb WorldCom case study and Paul Lee of Hermes allowed us touse his equally superb case studies of Premier Oil and Trinity Mirror We are deeply grateful.Becky Lawler, Jessica Thomas, Michelle Gayton, Beth Young, Jackie Cook, and PaulHodgson of the Corporate Library were generous, knowledgeable, and completely indispensable in giving us the latest data and analyses Carol Bowie of IRRC gave us important statistics about shareholder votes on compensation proposals Ric Marshall, our trusted colleague, developed the website that has made it possible for us to includeand update the book’s supporting materials Manpower CEO Mitchell Fromstein was most generous not only with useful material but also his own time Newton Minow andthe late Stanley Frankel constantly sent us clippings and gave us thoughtful advice.There is a special section of heaven for those who are willing to trudge through earlydrafts and provide comments Thanks very much to Margaret Blair, Alfred Conard, WayneMarr, Jane Zanglein, and Stu Gillan

We want to thank our colleagues, including everyone at the three companies we haveworked at together: Institutional Shareholder Services, Lens, and the Corporate Library.Barbara Sleasman is the finest professional with whom we have ever worked Cheri Gaudetwas wonderfully diligent on updating and organizing the manuscript We would also like

to thank the people at Blackwell’s, including Linda Auld, Rhonda Pearce, and RosemaryNixon Alexandra Lajoux was a brilliant (and tactful) editor

Note from Bob Monks: I sometimes feel like Samuel Taylor Coleridge’s famed wedding guest

“who stoppeth one of three” and proceeds to regale each with his memorable tale Inview of my utter preoccupation with this book and its subject matter, I am profoundlygrateful for the civility and forbearance of friends and family and the love and understanding

of my wife – Milly – and partners – Barbara and Nell

Note from Nell Minow: Thanks and love to my extended family, including all of the Minows

and Apatoffs; my friends Kathy and Andrew Stephen, Kristie Miller, Patty Marx, JeffSonnenfeld, Jesse Norman, Tom Dunkel, Judy Viorst, Sarah Teslik, Adam Frankel, JudyPomeranz, Cynthea Riesenberg, the Klein and Marlette families, Nadine Prosperi,Deborah Baughman, Jon Friedman, Desson Howe, Deborah Davidson, John Adams, ShannonHackett, David Drew, Beth Young, Ann Yerger, Terry Savage, Bill Pedersen, Gary Waxman,Sarah Kavenaugh, Jane Leavy, Isabel Contreras, Steve Wallman, Sam Natapoff, Toby Kent,Michael Kinsley, Parvané Hashemi, Ken Suslick, Ellen and Sandy Twaddell, Steve Friess,Duncan Clark, Ellen Burka, Jim Richter, Michael Deal, and Stuart Brotman Very specialthanks to two very special girls, Lauren Webster and Alison Anthes Thanks, as ever, toBob Monks, the perfect partner

Most of all, I want to thank my family – my children, Benjamin and Rachel, and myhusband, David, still the best person I know

The importance of corporate governance became dramatically clear in 2002 as a series

of corporate meltdowns, frauds, and other catastrophes led to the destruction of billions ofdollars of shareholder wealth, the loss of thousands of jobs, the criminal investigation ofdozens of executives, and record-breaking bankruptcy filings Seven of the 12 largest bankrupt-cies in American history were filed in 2002 alone The names Enron, Tyco, Adelphia,WorldCom, and Global Crossing have eclipsed past great scandals like National StudentMarketing, Equity Funding, and ZZZZ Best Part of what made them so arresting washow much money was involved The six-figure fraud at National Student Marketing seemsalmost endearingly modest by today’s standards Part was the colorful characters, from thosewho were already well known, like Martha Stewart and Jack Welch, to those who becamewell known when their businesses collapsed, like Ken Lay at Enron and the Rigas family at Adelphia Part was the breathtaking hubris – as John Plender says in his 2003

book, Going Off the Rails, “Bubbles and hubris go hand in hand.” And then there were

the unforgettable details, from the $6,000 shower curtain the shareholders unknowinglybought for Tyco CEO Dennis Kozlowski to the swap of admission to a tony pre-school

in exchange for a favorable analyst recommendation on ATT at Citigroup

Another reason for the impact of these stories was that they occurred in the context of

a falling market, a drop off from the longest, strongest bull market in US history In the1990s we saw billions of dollars of fraudulently overstated books at Cendant, Livent, RiteAid, and Waste Management, but those were trivial distractions in a bull market fueled

by dot.com companies Those days were so heady and optimistic that you didn’t need tolie Why create fake earnings when an honest disclosure that you had no idea when youwere going to make a profit wouldn’t stop the avalanche of investors ready to give Palm

a bigger market cap than Apple on the day of its IPO?

But the most important reason these scandals became the most widely reported estic story of the year was the sense that every one of the mechanisms set up to providechecks and balances failed at the same time

dom-All of a sudden, everyone was interested in corporate governance The term was evenmentioned for the first time in the president’s annual State of the Union address Massivenew legislation, the Sarbanes-Oxley Act, was quickly passed by Congress and the SEChad its busiest rulemaking season in 70 years as it developed the regulations to implement

it The New York Stock Exchange and NASDAQ proposed new listing standards thatwould require companies to improve their corporate governance or no longer be able to

I NTRODUCTION

trade their securities The rating agencies, S&P and Moody’s, who had failed to issue earlywarnings on the bankrupt companies, announced that they would factor in governance

in their future analyses Corporate governance is now and forever will be properly stood as a element of risk – risk for investors, whose interests may not be protected byineffectual or corrupt managers and directors, and risk for employees, communities,lenders, suppliers, and customers as well

under-Just as people will always be imaginative and aggressive in creating new ways to makemoney legally, there will be some who will devote that same talent to doing it illegally,and there will always be people who are naive or avaricious enough to fall for it Scamartists used to use faxes to entice suckers into Ponzi schemes and Nigerian fortunes Now,they use e-mail Or, sometimes, they use audited financial reports

Were the scandals of 2002 any worse in scope or magnitude than they have ever beenbefore? Most of the focus has been on less than a dozen of the thousands of publicly tradedcompanies, and the overwhelming majority of executives, directors, and auditors are onthe level

If the rising tide of a bull market lifts all the boats, then when the tide goes out some

of those boats are going to founder on the rocks That’s just the market doing its orable job of sorting Some companies (and their managers and shareholders) got a freeride during the 1990s due to overall market buoyancy If the directors and executives weresmart, they recognized what was going on and used the access to capital to fund theirnext steps If they were not as smart, they thought they deserved their success If theywere really dumb, they thought it would go on for ever

inex-One factor that can make the difference between smart and dumb choices is corporategovernance In essence, corporate governance is the structure that is intended to makesure that the right questions get asked and that checks and balances are in place to makesure that the answers reflect what is best for the creation of long-term, sustainable value.When that structure gets subverted, it becomes too easy to succumb to the temptation toengage in self-dealing

Case in point: Should the Chicago

Cubs play night games?

Can CEOs decide not to pursue opportunities that will increase revenues? In 1968, some shareholders of the Wrigley Corporation sued the company and its directors for failing to install lights in Chicago’s Wrigley Field The shareholders claimed that the company’s operating losses for four years were the result of its negligence and mismanagement If the field had lights, the Cubs could play at night, when revenues from attendance, concessions, and radio and television broadcasts were the greatest The shareholders argued that the sole reason for failing to install the lights was the personal opinion of William Wrigley, the president of the com- pany, that baseball was a daytime sport, and that night games would lead to a deterioration of the neighborhood “Thus,” the complaint concluded, “Wrigley and the directors who acquiesced in this policy were acting against the financial welfare

of the Cubs in an arbitrary and capricious manner, causing waste of corporate assets They were not exercising reasonable care or prudence in the management

of the corporation’s affairs.” 1

The court ruled against the shareholders As long as the decision was made

“without an element of fraud, illegality, or conflict of interest, and if there was no

showing of damage to the corporation, then such questions of policy and

man-agement are within the limits of director discretion as a matter of business ment,” the court ruled (emphasis added).

judg-Do you agree with this result? Should the management of a public corporation (a company receiving capital from the public) be able to forgo additional returns to shareholders on the basis of a CEO’s personal opinions about the company’s prod- uct? How relevant are concerns about whether baseball should be played at night and the impact on the neighborhood? More important, who is in the best posi- tion to decide how relevant those concerns are? Does it affect your answer to know that every other major league playing field had night games? Does it affect your answer that Mr Wrigley, at the time of this case, held 80 percent of the company’s stock? If it does change your answer, how? And why?

Case in point: Should AT&T owners

pay for propaganda?

Is a corporation entitled to free speech? A Massachusetts statute prohibited porations from making expenditures to influence the vote on “any questions sub- mitted to the voters, other than one materially affecting any of the property, business,

cor-or assets of the ccor-orpcor-oration.” The law made it clear that this prohibition extended

to all tax issues, even those that did “materially affect” the company The statute was declared unconstitutional because it infringed the First Amendment rights of the company to freedom of speech 2 Two justices of the Supreme Court who heard

a case raising some similar issues had opposite reactions.

Justice William Brennan did not want corporate management to use the shareholders’ money to promote their ideas: “The State surely has a compelling interest in preventing a corporation it has chartered from exploiting those who do not wish to contribute to the Chamber’s political message ‘A’s right to receive information does not require the state to permit B to steal from C the funds that alone will enable B to make the communication.’ ” 3

Justice Anton Scalia thought it was worthwhile to bring ideas to the marketplace, and he did not worry that the extra support for those ideas from the corporate bank account would sway anyone otherwise unwilling to buy them: “The advocacy

of [AT&T or General Motors] will be effective only to the extent that it brings to the people’s attention ideas which – despite the invariably self-interested and prob- ably uncongenial source – strike them as true.” 4

Do you agree with this result? What do you think was the rationale for such a statute in the first place? Should the management of a public corporation be able

to use the shareholders’ money to express its views (or further its political agenda) when those views may not be shared by the people who are paying the bill?

A corporation is an entity created by law that has some of the same rights as individuals – does that include all of the freedom of speech rights granted to individuals by the Constitution?

The Supreme Court has expanded the protections for the oxymoronic “commercial freespeech” since this ruling In a 2002 case called Thompson v Western States Medical Center,the court invalidated a statute that prohibited the advertising of “compounded” drugs, medications created for specific patients by combining two approved drugs Because thecombined form of the drugs had not received FDA approval, the law permitting theirmanufacture prohibited their being advertised But the court found that the governmentcannot legitimately deny the public truthful commercial information to prevent the

public from making bad decisions with the information Why not? How does this fit with the traditional justification for freedom of speech?

Authors Russel Mokhiber and Robert Weissman argue, “If the Court is going to tify commercial speech protections based on the public’s right to know, as opposed to thespeaker’s right to speak, it makes sense for the government to make determinations aboutwhether the commercial information actually will educate the public to advance publicpolicy goals It is hardly a revelation that advertising contains promotional elements that

But the California Supreme Court found that Nike’s inaccurate reports about pay and working conditions in its overseas factories were not protected as commercial speech,even though they addressed what might be considered political matters rather than justadvertising its products The intention of the statement was to encourage people to buysneakers, so the court ruled that they were entitled only to the narrower protection given

to advertising and other forms of commercial speech The United States Supreme Courthas deferred its ruling pending further fact finding

Case in point: Who pays the penalty when babies drink sugar water?

How do you punish a corporation? The president and vice-president of Beech-Nut admitted that they knowingly permitted adulterated apple juice to be sold for babies The babies who drank the juice, of course, had no way of knowing that the juice was not right, and no way of communicating it if they did The company pled guilty

to 215 counts of violating federal food and drug laws, and paid a $2 million fine.

According to the New York Times, its market share dropped 15 percent The

pres-ident and vice-prespres-ident were not fired On the contrary – the company paid all of their legal fees and their salaries until their appeals ran out No one from the com- pany ever went to jail or paid a fine out of his own pocket On the witness stand, one of the executives explained his decision to continue to market the adulterated juice: “What was I supposed to do? Close down the factory?”

Is this the right result? What would be the result if the men involved had sold adulterated apple juice from a street corner or a local store, without the pro- tection of the corporate structure? Is it fair for the shareholders to pay the fine

in addition to suffering the reduction in share value? What was the executive posed to do? Once he found out that the juice was adulterated, should he have closed down the factory? What reporting structure or incentive structure or set

sup-of guidelines for employees would be most likely to achieve the best result? Who will or should go to jail because of the frauds at Enron, Global Crossing, WorldCom, Adelphia, and the others?

There is one theme to all three of these cases, and indeed to all problems of corporategovernance, and that is the issue of agency costs The price we all pay for the benefits ofthe corporate structure is our loss of control Investors lose control over the use of theircapital Managers lose control over their sources of funding Other participants in the cor-porate structure – employees, creditors, and so forth – also lose some measure of control.The board has the oversight responsibility It monitors the extent to which the variouscorporate participants retain control, the costs and benefits of their attempts to do so, andthe resulting balance of powers among them.

Case in point: A CEO’s perspective

These excerpts are from a speech by a leading CEO at a 1999 conference on ethics and corporate boards:

[A] strong, independent, and knowledgeable board can make a significant ence in the performance of any company [O]ur corporate governance guide- lines emphasize “the qualities of strength of character, an inquiring and independent mind, practical wisdom and mature judgment ” It is no accident that we put “strength of character” first Like any successful company, we must have directors who start with what is right, who do not have hidden agendas, and who strive to make judgments about what is best for the company, and not about what is best for themselves or some other constituency

differ-[W]e look first and foremost for principle-centered leaders That includes principle-centered directors The second thing we look for are independent and inquiring minds We are always thinking about the company’s business and what we are trying to do We want board members whose active par- ticipation improves the quality of our decisions.

Finally, we look for individuals who have mature judgment – individuals who are thoughtful and rigorous in what they say and decide They should be people whom other directors and management will respect and listen to very carefully, and who can mentor CEOs and other senior managers The responsibility of our board – a responsibility which I expect them to fulfill – is to ensure legal and ethical conduct by the company and by everyone in the company That requirement does not exist by happenstance It is the most important thing we expect from board members

What a CEO really expects from a board is good advice and counsel, both of which will make the company stronger and more successful; support for those investments and decisions that serve the interests of the company and its stake- holders; and warnings in those cases in which investments and decisions are not beneficial to the company and its stakeholders.

That speech, “What a CEO Expects from a Board,” was delivered by then Enron CEOKenneth Lay The company’s code of ethics is similarly impressive The company got highmarks from just about everyone for best corporate governance practices

The board looked good on paper: the former dean of the Stanford business school waschairman of the audit committee Another director was formerly a member of the BritishHouse of Lords and House of Commons, as well as Energy Minister In addition, theboard included one of the most prominent business leaders in Hong Kong, the co-founderand former president of Gulf and Western, two sitting CEOs of large U.S corporations,

and the former head of the Commodities Futures Trading Corporation, who was an Asianwoman with an economics Ph.D., and married to a prominent Republican congressman.There was also a former professor of economics and a former head of General Electric’sPower Division worldwide, a senior executive of an investment fund with a Ph.D inmathematics, the former president of Houston Natural Gas, the former head of M D.Anderson, the former head of a major energy and petroleum company, and a former DeputySecretary of the Treasury and Ph.D economist.

That shows that it is easy to achieve the letter of good corporate governance withoutachieving the spirit or the reality While it is tempting to engage in checklists of struc-tural indicators, there is no evidence that intuitively appealing provisions like independentoutside directors rather than people whose commercial or social ties might create conflicts

of interest, or annual election of directors rather than staggered terms have any tion to the creation of shareholder value or the prevention of self-dealing Therefore, it

correla-is important to keep in mind throughout thcorrela-is book that corporate governance correla-is aboutmaking sure that the right questions get asked and the right checks and balances are inplace, and not about some superficial or theoretical construct

William Donaldson, Chairman of the Securities and Exchange Commission, made thispoint in a 2003 speech at the Washington Economic Policy Conference:

a “check the box” approach to good corporate governance will not inspire a true sense

of ethical obligation It could merely lead to an array of inhibiting, “politically correct”dictates If this was the case, ultimately corporations would not strive to meet higherstandards, they would only strain under new costs associated with fulfilling a mandatedprocess that could produce little of the desired effect They would lose the freedom tomake innovative decisions that an ethically sound entrepreneurial culture requires

As the board properly exercises its power, representing all stakeholders, I would gest that the board members define the culture of ethics that they expect all aspects ofthe company to embrace The philosophy that they articulate must pertain not only theboard’s selection of a chief executive officer, but also the spirit and very DNA of thecorporate body itself – from top to bottom and from bottom to top Only after the boardmeets this fundamental obligation to define the culture and ethics of the corporation –and for that matter of the board itself – can it go on and make its own decisions aboutthe implementation of this culture

sug-In this book we will focus on the three most significant players in the corporate cess: shareholders, managers, and directors Together, these forces shape a corporation’sfocus, its direction, its productivity and competitiveness, and ultimately, its viability andlegitimacy First, however, we will begin with an inquiry into the nature of the corpora-tion itself

1 Shlensky v Wrigley, 95 Ill App 2d 173, 237 (1968).

2 First National Bank of Boston v Bellotti, 435 US 765 (1978).

3 Austin, Michigan Secretary of State, et al v Michigan State Chamber of Commerce, Brennan’s

concurring opinion, p 7

4 Ibid., Scalia’s dissent, p 5

5 “The Final Call,” Sept 24, 2002 24-2002.htm>

<http://www.finalcall.com/perspectives/free_speech09-Ideas about corporations

Concentration of economic power in all-embracing corporations represents a kind

of private government which is a power unto itself – a regimentation of other

people’s money and other people’s lives Franklin Roosevelt

The myth that holds that the great corporation is a puppet of the market, the

powerless servant of the consumer, is, in fact, one of the services by which its power is perpetuated John Kenneth Galbraith

Merchants have no country The mere spot they stand on does not constitute so

strong an attachment as that from which they draw their gains Thomas Jefferson

By making ordinary business decisions [corporate] managers now have more power than most sovereign governments to determine where people will live; what work they will do, if any; what they will eat, drink, and wear: what sorts of knowledge, schools, and universities they will encourage; and what kinds of society their chil-

dren will inherit Richard J Barnet and Ronald Mueller

Corporations, especially the large and complex ones with which we have to live, now appear to possess some of the qualities of nation states including, perhaps,

an alarming capacity to insulate their members from the moral consequences of

their actions Paul Eddy, Elaine Potter, and Bruce Page

Definitions of the term corporation reflect the perspectives (and the biases) of the people

writing the definitions Anyone who tries to come up with a definition is like the blindmen who tried to describe an elephant – one feeling the tail and calling it a snake, onefeeling the leg and calling it a tree, one feeling the side and calling it a wall Similarly,some lawyers and economists describe the corporation as simply “a nexus (bundle) of con-tracts,” arguing that the corporation is nothing more than the sum of all of the agree-

corporation:

DEFINITIONS

“The business corporation is an instrument through which capital is assembled for theactivities of producing and distributing goods and services and making investments.Accordingly, a basic premise of corporation law is that a business corporation shouldhave as its objective the conduct of such activities with a view to enhancing the cor-poration’s profit and the gains of the corporation’s owners, that is, the shareholders.”

Melvin Aron Eisenberg2

“A corporation is an artificial being, invisible, intangible, and existing only in the templation of the law Being the mere creature of the law, it possesses only those prop-erties which the charter of its creation confers on it, either expressly or as incidental toits very existence These are such as are supposed best calculated to effect the object forwhich it was created Among the most important are immortality, and, if the expression

con-be allowed, individuality; properties by which a perpetual succession of many persons

are considered the same, and may act as a single individual.” Chief Justice John Marshall

“A body of persons granted a charter legally recognizing them as a separate entity

hav-ing its own rights, privileges, and liabilities distinct from those of its members.” American

Heritage Dictionary

“An artificial person or legal entity created by, or under the authority of, the laws of a

state The corporation is distinct from the individuals who comprise it.” Black’s Law

Dictionary, 6th edition, 1990

1

C ORPORATION ?

“When they [the individuals composing a corporation] are consolidated and united into

a corporation, they and their successors are then considered as one person in law forall the individual members that have existed from the foundation to the present time,

or that shall ever hereafter exist, are but one person in law – a person that never dies:

in like manner as the river Thames is still the same river, though the parts which

com-pose it are changing every instant.” Blackstone

“An ingenious device for obtaining individual profit without individual responsibility.”

Ambrose Bierce, The Devil’s Dictionary

What do these definitions tell you about the corporation? Are any of them incompatible, or

do they differ only in their emphasis? Can you think of a better definition?

All of these definitions have some validity, and all, including the one from The Devil’s Dictionary, reflect the corporation’s key feature – its ability to draw its resources from a

variety of groups and establish and maintain its own persona separate from all of them AsHenry Ford once said, “A great business is really too big to be human.”

In our view, a corporation is a mechanism established to allow different parties to tribute capital, expertise, and labor, for the maximum benefit of all of them The investorgets the chance to participate in the profits of the enterprise without taking responsibilityfor the operations The management gets the chance to run the company without takingthe responsibility of personally providing the funds In order to make both of these pos-sible, the shareholders have limited liability and limited involvement in the company’s affairs.That involvement includes, at least in theory, the right to elect directors and the fiduciaryobligation of directors and management to protect their interests

con-This independent entity must still relate to a wide variety of “constituents,” includingits directors, managers, employees, shareholders, customers, creditors and suppliers, as well

as the members of the community and the government Each of these relationships itselfhas a variety of constituents The corporation’s relationship to its employees varies, forexample, depending on the circumstances: whether or not they are members of a union,whether or not they are pension plan participants And each of these relationships affectsthe direction and focus of the corporation The study of corporate governance is the study

of the connection of those relationships to the corporation and to one another

EVOLUTION OF THE CORPORATE STRUCTURE

While, in law, a corporation is, at least for some purposes, considered to be a fictional

“person,” at its core each corporation is in fact a structure The corporate structure wasdeveloped to meet particular needs that were not being met by earlier forms available tobusiness It evolved through a Darwinian process in which each development made it stronger,more resilient, and more impervious to control by outsiders

As we examine that evolutionary pattern, it will become clear that every change thecorporate form has undergone has been directed toward the corporation’s own perpetuationand growth The advantages and disadvantages of this fact of business life are discussedthroughout this book

In their earliest Anglo-Saxon form, municipal and educational corporations weregranted perpetual existence and control over their own functions as a way of insuring

Figure 1.1 The Company Corporation advertisement

Reproduced with permission from The Company Corporation

independence from the otherwise all-encompassing power of the king By the seventeenthcentury, corporations were created by the state for specific purposes, like the settlement

of India and the American colonies Their effectiveness is credited as one of the principalexplanations for Europe’s half-millennium domination of the globe Limiting investors’liability to the amount they actually invested was a critical factor in attracting the necess-

Even as recently as 1932, US Supreme Court Justice Louis Brandeis argued that “Theprivilege of engaging in such commerce in corporate form is one which the state may

He emphasized the importance of making surethat states conferred the privilege of the corporate structure only in those cases where

it was consistent with public policy and welfare, as, for example, “as a means of raisingrevenue; or, in order to procure for the community a public utility, a bank, or a desired

industry not otherwise attainable; or an instrumentality of business which will facilitate

He noted that:

The prevalence of the corporation in America has led men of this generation to act,

at times, as if the privilege of doing business in corporate form were inherent in the citizen, and has led them to accept the evils attendant upon the free and unrestricted use

of the corporate mechanism as if these evils were the inescapable price of civilized life,and hence, to be borne with resignation Throughout the greater part of our history, adifferent view prevailed Although the value of this instrumentality in commerce andindustry was fully recognized, incorporation for business was commonly denied long after it had been freely granted for religious, educational, and charitable purposes It wasdenied because of fear Fear of encroachment upon the liberties and opportunities of the individual Fear of the subjugation of labor to capital Fear of monopoly Fear that theabsorption of capital by corporations, and their perpetual life, might bring evils similar tothose which attended mortmain.6There was a sense of some insidious menace inherent

in large aggregations of capital, particularly when held by corporations So at first thecorporate privilege was granted sparingly; and only when the grant seemed necessary inorder to procure for the community some specific benefit otherwise unattainable Thelater enactment of general corporation laws does not signify that the apprehension of cor-porate domination had been overcome.7

Brandeis points out that the decision to remove the strict requirements imposed on corporations was not based on the legislators’ “conviction that maintenance of these restric-tions was undesirable in itself, but to the conviction that it was futile to insist on them;

In other words,the characteristics of the corporate form were so important to people in business that leg-islators recognized that they could not beat them, and therefore might as well join them,

or at least permit and then tax them

What made the corporate form so appealing, so essential? According to Dean RobertClark of Harvard Law School, the four characteristics essential to the vitality and appeal

of the corporate form are:

He adds that three developments, starting in the late nineteenth century, made these attributesparticularly important The first was the need for firms far larger than had previously beenthe norm Technological advances led to new economies of scale For the first time itmade sense to have firms of more than a dozen people, and suddenly there were com-panies employing hundreds, then thousands The second was the accompanying need forcapital from a range of sources broader than in the past, when the only game in town was a small group of wealthy individuals who had previously invested by private negotiation The third condition was that private ownership of investment property had

to be “accepted as a social norm.” The concept hardly seems revolutionary now, but

it was radical, even a century ago, when it was widely assumed that most property would belong to the state, the church, or a select number of wealthy people While

this tradition was challenged from time to time, as, for example, during the Colonial andRevolutionary period of US history, the idea of widespread private property is essentially

a modern one

Let’s look at Clark’s four characteristics

1 Limited liability The notion of limited liability goes back to at least 2000 BC, when

merchants provided the financing for seagoing vessels But the English courts first spelled itout during the fifteenth century It means that the corporation is separate from its ownersand employees; what is owed to the corporation is not owed to the individuals in thegroup that make up the corporation; and what the group owes is not owed by the indi-viduals that make it up Hence, if a corporation goes bankrupt and is sued by its creditorsfor recovery of debts, the individual members of the corporation are not individually liable

If a dozen people pool their funds to create a partnership, they risk losing not just theirstakes, but everything they have Partners who operate a restaurant are personally liablefor debts to unpaid creditors and employees, for any injuries to a patron who sues afterfalling down the restaurant stairs, and for the misconduct of fellow partners, even of whichthey had no knowledge or control Investors in a corporation that operates a restauranthave no such risk If Beech-Nut (see case in point in the introduction) had been a partner-ship, all of the partners could have been liable to pay the fine as well as for any damagesthe court might award to the consumers who purchased the adulterated juice

This kind of shared liability may work well when the partnership is small enough toenable everyone to keep an eye on everyone else and share in all decisions, and when thepersonal investment of each partner is big enough to give each one the same incentive

But this oversight and incentive would be impossible in

a setting of not just dozens, but millions of “partners” investing in a company No onewould buy stock in a large corporation if the risk of loss were unlimited One of the primary advantages of investing in stock is the certainty that whatever happens, the risk

of loss is limited to the amount of the investment

There is a catch here, however With limited liability comes limited authority A partnerhas a co-equal right to run the company with all of the other partners (unless the partieshave agreed to another arrangement by contract) It is the partner’s high level of controlthat makes the high level of liability acceptable And it is the shareholder’s low level ofrisk that makes the low level of control acceptable

One other note on limited liability During the 1980s, another form of limited ity became popular, as a result of revisions in the bankruptcy law, giving shareholders asecond chance to profit from failing enterprises Airline companies were able to avoid unioncontracts and asbestos companies were able to avoid tort liability Most prominently ofall, Texaco was able to negotiate down the damages assessed against it arising out of thePennzoil acquisition It became expedient even for companies with substantial assets todeclare bankruptcy because of the protections – and the extra time – it gave them Ultimately,many of these companies emerged from bankruptcy with their liabilities better organized,and the shareholders – whose downside liability was always limited – were given a secondchance to profit

liabil-2 Transferability Just as important as limited liability in achieving an acceptable level of

risk is the ability to transfer one’s holding freely A partnership interest is complicated anddifficult to value, and there is no stock exchange where partnership interests can be traded

By contrast, stock is almost as liquid as cash A shareholder who is concerned that thestock may be losing value can sell almost immediately

Transferability is also a function of limited authority It is as though the shareholdersays, “I will put my money at risk, with little authority to control the enterprise, as long

as I can control my own risk by selling out any time I want to.”

3 Legal personality A partnership dies with its partners Or it dies when one partner

decides to quit (unless there are explicit contractual provisions to the contrary) tinuing after the death or resignation of the partners can be complicated and expensive

Con-A corporation lives on for as long as it has capital This is a fairly recent development.Business corporations in the United States during the nineteenth century usually had a life

limited to a term of years As Justice Brandeis wrote in Liggett v Lee, only in the most

recent times have people assumed that perpetual existence was a necessary – to say nothing

of a desirable – attribute of corporations

Legal personality has other benefits as well One is demonstrated by the Beech-Nutexample in the introduction, where actions that would result in a penalty for an indi-vidual, perhaps even a jail sentence, have no such result when the individual commitsthem as part of a corporation Another is in the First Amendment example in the intro-duction, where corporate management is allowed to use investors’ money to promote

a political agenda with which they may not agree Another is ownership It is becausecorporations are defined as legal persons that they may own property, including real estate,copyrights, and other assets

This aspect, too, depends on limited authority by investors To the extent the investors

do have authority, they jeopardize the company when they are unavailable to exercise it.Legal personality allows the corporation to act, to own, and to continue past the life span

of any individual or group

4 Centralized management Partnerships are managed by consensus or majority vote (unless

partners explicitly agree otherwise) The point is that every partner has, if he wants it, aco-equal say in the affairs of the company In a corporation, the power to determine thecompany’s overall direction is given to the directors and the power to control its day-to-day operations is given to the managers

This is another aspect of the limited authority given to investors In order to allow thecompany to operate with maximum efficiency, the shareholders give up the right to makedecisions on all but the most general issues facing the company

Initially, a corporation was not permitted to engage in any activity unless it was specificallyapproved by the state in granting its charter The original rule was based on the state’s

presumption against corporate activity; every undertaking had to be explicitly justified and

approved But as the corporate form became increasingly popular, the presumptionshifted By the late nineteenth century, business corporations were permitted to organizefor any lawful purpose, without requiring the prior approval of the government

Just as dramatic – and just as important – as this shift in the relationship between thecorporation and the government was the shift in the relationship between the corpora-tion and its shareholders As corporations grew in size and age, their ownership becameincreasingly fractionated and markets developed to assure almost total immediate liquid-ity This increased their strength and scope, but it reduced their accountability In theearly days, when the directors sat around a real board, they represented the shareholders

because they were the shareholders As corporations grew in size and complexity, the

law tried to develop a standard of performance for directors that would encourage thesame sense of duty and care that they would naturally use when they were representingthemselves

THE PURPOSE OF A CORPORATION

Corporations are such a pervasive element in everyday life that it is difficult to step backfar enough to see them clearly Corporations do not just determine what goods and servicesare available in the marketplace, but, more than any other institution, corporations deter-mine the quality of the air we breathe and the water we drink, and even where we live

It helps to spend some time talking about the purposes that corporations serve

Human satisfaction

Business corporations provide an outlet for the satisfaction of essential human drives – questsfor fulfilment, success, and security, for creative expression and for the competitive spirit.The corporate structure allows value to be placed on differing contributions that combinetogether so that the whole is greater than the sum of its parts Through corporations, skills and experience can be competitively marketed and rewarded according to their contribution to value Corporations have provided a means for the ambitious to achieve,the enterprising to prosper, and the ingenious to be enriched beyond their fondest expectations – the role played by the church or the military or the crown at other timesand in other cultures Ideally, money invested buys perpetual ownership in a cornucopia

of self-renewing abundance Only the amount invested is at risk, and, if an investor buysownership in several companies, that risk can be spread, and a portfolio corporation can

be divested at any time to reduce significantly the possibility of loss

Above all else, creating a structure for the agglomeration of talent and capital has permitted an increasing number of individuals the opportunity to create wealth for them-selves and their descendants

Social structure

Human beings have created social structures since their cave days, in order to foster operation and specialization Corporations offer lasting and resilient social structures Forcenturies, these structures were devoted to goals that were not (necessarily) financial Forexample, during the Dark Ages and the Middle Ages, Western man was organized underthe single church Toward the end of the medieval era, signs of this “church triumphant”system abounded Under its banner, whole populations committed themselves for decades

co-to the Crusades The gross national product of the continent was devoted co-to the construction

of magnificent houses of worship Then, in a remarkable turn of events aided by religiousprotest, Henry VIII abruptly asserted the primacy of civil authority For several centuries,

up to the end of World War I, civil order based on hereditary rulers dominated the West

At about this time, power in the form of ability to create wealth through goods andservices desired by a population willing to pay passed to an entirely new type of entity,the huge worldwide corporations (see the Standard Oil case study in chapter 2)

Efficiency and efficacy

Corporations enable people to get things done The words “businesslike,” “professional,” and

“enterprise” are synonymous with beneficial efficiency and efficacy The translation of an ideainto a product; human ingenuity into bricks, mortar, and equipment; and savings into “growthstocks,” has materially enhanced the lives of many people in democratic capitalist societies

The challenge has been to adapt the corporate form to the needs of society To thisend, the state has maintained the original corporate model, chartering special-purpose corporations to achieve a particular objective For example, in order to assure better con-trol by America of its fuel needs, the US Congress created the United States SyntheticFuels Corporation in 1980 and attempted to use private sector personnel and techniques

to solve a public problem Similarly, organizations such as the Federal National MortgageAssociation show the government’s recognition that if it is going to compete with WallStreet, it must be through a private, for-profit organization That organizations own cor-porate governance problems in 2003 – the abrupt departure of the top three executivesamid accusations of accounting problems – shows that this public–private combination is

no better at preventing abuse than one that is strictly government or strictly private.This works both ways, of course It is an understatement to say that the governmentdoes not hesitate to regulate corporations for a variety of reasons, some tangential to thecorporation’s activities Society can induce or restrain particular corporate activitiesthrough tax and regulatory “fine-tuning.” For example, much New Deal legislation attempted

to achieve social goals while pursuing economic ones The Davis–Bacon Act of 1931 isone of three labor statutes passed in the 1930s to protect workers employed on govern-ment contracts Davis–Bacon provides minimum wage requirements and fringe benefitsfor government-employed construction workers More recent examples include laws andregulations designed to promote safety in the workplace and prohibiting discrimination

on the basis of age, race, gender, and disability, rules requiring employers to grant

“family leave” to those who required it, and rules enlisting private companies to help gatherinformation on suspected terrorists

Ubiquity and flexibility

Corporations give individuals a greater and more lasting sphere of action Corporationshave no boundaries in time or space A corporation continues despite the death or retire-ment of its highest officers A corporation that is chartered in Delaware can do businessanywhere in the world Corporations can be moved They can be transformed by a revi-sion to their legal or financial structure A corporation’s officers and directors can change itsplace of incorporation, close existing places of business and open new ones virtually withoutrestraint, and reallocate investment capital American companies change their state of incor-poration to receive the benefits of favorable laws, or reincorporate offshore for tax reasons.The free trade agreements in Europe and Northern America are creating a “borderlessworld” in which a company’s legal domicile relates to nothing but its own convenience

An individual may decide to refrain from certain risky actions for several reasons Hemay fear blame, shame, liability, even prison But corporations, though they may be fined,cannot be jailed This makes the corporate form a way of transferring enterprise liabilities

to society as a whole With their ability to provide jobs, corporations are aggressively courted

by competing locations and states and countries, who “race to the bottom,” imposing fewerand fewer constraints on profit potential The state anti-takeover laws enacted hastily to pro-tect local companies from the prospect of a contest for control (even, as in Massachusetts,signed by the governor in the headquarters of the company in question) are just one example

Identity

Indeed, corporations have a life, and even citizenship, of their own, with attendant rightsand powers They appear to have personalities We speak of “Ma Bell” and “Big Blue.”

Corporations are “persons” within the meaning of the United States Federal Constitutionand Bill of Rights They are entitled to protection against the taking of their propertywithout due process of law They are entitled (at least to some extent) to freedom of speech.They can contribute money to political causes and campaigns, though some restrictionsapply, due to post-Watergate reforms.

As the source of jobs, and therefore of the livelihood for people who vote, they havesignificant political capital Corporations, therefore, are powerful participants in the delib-erations of our lawmakers

Corporations also decide what products and services will be available This applies notjust to laundry soap and toothpaste, but also to medications and safety equipment Theydecide investment priorities They establish workplace conditions They set prices

THE CORPORATION AS A “PERSON”

Author and reporter William Greider describes the development of corporate “personalities”:The great project of corporate lawyers, extending over generations, has been to estab-lish full citizenship for their business organizations They argue that their companies are entitled to the same political rights, save voting, that the Constitution guarantees topeople In 1886 the Supreme Court declared, without hearing arguments, that corpora-tions would henceforth be considered “persons” for purposes of the 14th Amendment– the “due process” amendment that was established to protect the newly emancipatedblack slaves after the Civil War Fifty years later, justice Hugo Black reviewed the SupremeCourt’s many decisions applying the 14th Amendment and observed that less than onehalf of one percent invoked it in protection of the Negro race, and more than 50 percentasked that its benefits be extended to corporations

In the modem era of regulation [corporate lawyers] are invoking the Bill of Rights

to protect their organizations from federal laws Corporations, in other words, claim

to be “citizens” of the Republic, not simply for propaganda or good public relations, but

in the actual legal sense of claiming constitutional rights and protections Whateverlegal theories may eventually develop around this question, the political implications are profound If corporations are citizens, then other citizens – the living, breathing kind– necessarily become less important to the processes of self-government.11

THE CORPORATION AS A COMPLEX ADAPTIVE SYSTEM

In the authors’ first book, we said that the corporate structure was designed to be so vitaland robust that it was like an “externalizing machine.” There is no malice involved – it

is just the flip side of its purpose of wealth generation Therefore, it will do whatever itcan to hang on to its earnings and push its costs off of its balance sheet This can be done,for example, through legislation that increases barriers to entry for its competitors or limits its liabilities The self-perpetuating life force built into the corporate structure fightsthe systems intended to impose accountability, and through that, legitimacy

“Externality” is the vocabulary of economics Another way to think about this is to usethe vocabulary of science and call it a “complex adaptive system.”

These systems, whether in physics, biology or economics, can be analyzed as patternsand modes of behavior that can inform activity in other fields One cannot literally find

in corporate behavior a repetition of the interaction of subatomic particles; one can,

how-ever, notice living patterns that seem to replicate in corporate experience – tendenciestowards immortality, for unlimited size, unlimited power, unlimited license.

Only when one understands that corporations have adaptive characteristics does it becomeclear that modification of their behavior must come from within the organizations It hasnot been convenient for society to recognize the general ineffectiveness of externalrestraints on corporate activity Neither government nor marketplace has the capacity torequire corporate functioning to conform to society’s interests Large corporations retainthe services of the most talented professionals, the most persuasive lobbyists: former SenatorGeorge Mitchell, “hero” of the Irish peace talks, is the principal lobbyist for the tobaccoindustry They control the most influential newspapers, TV (all three American networksare owned by diversified conglomerates – GE, Disney, and Westinghouse) and magazineoutlets, and the best lawyers With such competitive strength, it is difficult for the widelydispersed elements that comprise society to effectively assert a contrary view They evencontrol their own shareholders; the corporations themselves are the largest investorsthrough their pension funds, often the greatest asset and liability even a major corpora-tion has on its balance sheet For example, in 2001, General Motor’s pension assets of $74billion were worth 271 percent of the company’s market capitalization And in 2003 the

Washington Post reported that the $19 billion under-funding of GM’s pension fund was

driving the company to slash car prices to raise money quickly This astonishing opment – a pension deficit as the driver of corporate strategy – had a predictable result.GM’s competitors also discounted prices, resulting in reduced margins and earnings forthe entire sector The only way in which to attempt societal harmony with corporations

devel-is to understand that they are complex adaptive systems and change must come from within

THE CORPORATION AS A “MORAL PERSON”

Thomas Donaldson provides an analytical structure to consider how a corporation can bestructured to make “moral” decisions:

In order to qualify as a moral agent, a corporation would need to embody a process ofmoral decision making On the basis of our previous discussion, this process seems torequire at a minimum:

1 The capacity to use moral reasons in decision-making

2 The capacity of the decision-making process to control not only overt corporateacts, but also the structure of policies and rules

[The first] is necessary to raise the corporation above the level of a mere machine To

be a moral agent, something must have reasons for what it does, not simply causes forwhat it does, and for something to be a moral agent, some of those reasons must bemoral ones Obviously, corporations are unable to think as humans, but they can employreasons of a sort, and this is shown by the fact that they can be morally accountable.That is, with the proper internal structure, corporations, like humans, can be liable togive an account of their behavior where the account stipulates which moral reasons promptedtheir behavior.12

Can business “do well by doing good?” This is a perennial question On one end of thescale, companies such as Body Shop and Ben and Jerry’s have made social responsibility(or, at least, their view of social responsibility) part of their marketing strategy Consumerscan feel less guilty about buying arguably decadent products like make-up and ice cream

if they know that by doing so they are supporting good causes But can companies thrivewhen the cost of social responsibility raises prices too high, instead of making the prod-ucts more marketable making them less so? Clearly, there is some point past which the

At one end of the scale are the most basic aspects of social responsibility, like pliance with the law At the other end of the scale are activities so unrelated to the goodsand services sold that pursuing them is considered by the marketplace to be irrelevant,even detrimental, to the company’s productivity

com-Look again at the very first example in this book – the lawsuit challenging the decision not to put lights in Wrigley Field This decision, which deprived the fans of nightgames and the investors of a substantial source of revenue, was made on the basis of management’s notion of social responsibility Later we will consider the example of Stride Rite, which profited from its (well-deserved) reputation for commitment to thecommunity, while it was making the (economically necessary) decision to move jobs out

of the community

The key question here, one of the core issues of corporate governance, is “Who decides?”

A CEO can decide that the company’s social responsibility is best met by making a stantial charitable donation to his or her alma mater, which then shows its gratitude bygiving the CEO an honorary degree and a box at the school’s football games There isalso a very happy and congenial member of the board of directors when the university’spresident is invited to the board But is this “social responsibility?”

sub-Who is in the best position to make sure that any expenses not directly associated with identifiable and quantifiable returns are at least related closely enough to have a cost-effective impact on long-term value maximization? Who is in the best position to make sure that the company’s definition of social responsibility is an accurate reflection of the definition of the owners? Of the community?

Case in point: Union Carbide and Bhopal – what happens when the

company is bought out?

This is how a successor/purchaser corporation characterized a devastating ical spill, acknowledging the tragic consequences, absolving itself of responsibility, but portraying itself as a generous and concerned entity.

chem-From the Dow Chemical website <http://www.bhopal.com/position.htm>:

What happened in Bhopal 18 years ago was a tragedy of unprecedented gravity and human cost, which no one in industry will ever forget.

During the early hours of December 3, 1984, methyl isocyanate gas (known

as MIC) leaked from a storage tank sited at a pesticide manufacturing facility in Bhopal As it escaped, the gas drifted across the neighboring communities with devastating consequences According to the Indian government, some 3,800 people died and thousands more were injured as a direct result of exposure to the lethal fumes.

When the disaster occurred, the Bhopal plant was operated by Union Carbide India Limited (UCIL), a 51 percent affiliate of Union Carbide Corporation At that time, Dow had absolutely no connection with either the facility or any of the com- panies linked to the incident.

But 16 years after the tragedy, on February 6, 2001, Dow acquired Union Carbide’s shares Before doing so, as you might expect, the company conducted

an exhaustive assessment to ensure there was absolutely no outstanding liability

in relation to Bhopal There was none; the company Dow acquired retained lutely no responsibility for either the tragedy or for the Bhopal site.

abso-That conclusion was based on a number of key facts:

• On February 14, 1989, a settlement agreement was reached between Union Carbide, Union Carbide India Limited and the Indian government through which Union Carbide paid $470 million in compensation, covering all claims relating

to the incident.

• On October 3, 1991, the Supreme Court of India announced the findings of its review of the settlement agreement They upheld the settlement – concluding that the amount was just, equitable and reasonable.

• Within those same findings, the Supreme Court also directed that the Government of India make up any shortfall which might in the future arise in the settlement fund and ordered it to purchase a group medical insurance policy to cover 100,000 citizens of Bhopal in case of future illnesses These measures were specifically put in place to address any potential future issues arising from the tragedy.

• Two years later, on October 4, 1993, the US Supreme Court reaffirmed ier US Court rulings that the only State with jurisdiction in the case against Union Carbide on matters relating to the Bhopal tragedy was India They based this decision on the fact that UCIL was a separate and independent legal entity, managed and operated exclusively by Indian citizens in India.

earl-• In November 1994 – more than six years before Dow acquired Union Carbide – Union Carbide sold its interest in Union Carbide India Limited to MacLeod Russel (India) Ltd of Calcutta (later renamed Eveready Industries India Ltd –

or EIIL) As a consequence of that sale, Union Carbide retained no interest in

or liability for the Bhopal site EIIL took exclusive possession of the land under lease from the government of Madhya Pradesh The money from this trans- action was used to fund a hospital in Bhopal which now provides specialist care to victims of the tragedy.

• In 1998, the government of Madhya Pradesh revoked the EIIL lease for the Bhopal site, reclaiming the property “as is” and stating it would take respons- ibility for managing any cleanup or remediation work required on the site.

All of this means that when Dow completed its stock acquisition in February 2001, Union Carbide retained no responsibility whatsoever in relation to the tragedy But of course there is also an entirely separate humanitarian question – that is: can Dow, in its role as a corporate citizen, help to address any of the pre- sent day needs which are apparent in Bhopal?

That is why, for some time, Dow has been exploring various initiatives which might address some of those needs – just as we do in other parts of the world where we have business interests This work continues and we remain hopeful that we can find an appropriate initiative in the not too distant future.

The issues surrounding Bhopal are extremely emotive It is a tragedy that should never have happened Like the rest of industry, Dow has an obligation to learn from what took place that terrible night and to take whatever measures are necessary to prevent anything like it from ever happening again.

Case in point: Imperial Chemical

Industries plc

In 1993, Sir Denys Hendersen explained to his shareholders why he was ing to downsize Imperial Chemical Industries (ICI), a dominant company in one of the most important worldwide industries – the chemical and pharmaceutical busi- ness ICI had sales in the tens of billions of dollars, earnings in the billions and employees in the hundreds of thousands Yet in 1993 it proposed a “demerger”

propos-of a major unit, Zeneca.

A detailed proposal was sent to shareholders to explain the move The company cited “important, broader trends,” including “intensified competition in industrial chemicals, most notably from the Middle East and Asia Pacific, increased costs

of maintaining and developing new technology, especially in the bioscience areas, together with the adverse effects of the worldwide economic recession which began

in 1990” as reasons for the demerger In response to these trends, ICI pledged

“to reshape its operations focusing on those businesses and territories where

it enjoyed strong market positions, reducing costs in order to remain competitive and disposing of non-strategic operations These measures continue to be vigor- ously implemented, although the profit improvement benefits to date have been more than offset by the impact of the economic recession.”

Henderson continued in the traditional language of business and finance, ing, “In recent years, ICI’s bioscience activities have expanded rapidly and have become increasingly distinct from its traditional chemical operations, and both face very different opportunities and challenges in the years ahead The bioscience activities employ different technologies, are more R&D intensive and serve a largely separate customer base The Chemicals businesses are, in contrast, for the most part capital intensive, volume driven and based on large scale process technology.”

explain-What was more important, however, was what Henderson left out He did not mention Hanson Industries, whose purchase of a significant stock position in ICI was widely credited with being the prime cause of the demerger ICI had performed poorly for some years, and its stock price had become heavily discounted as a result Hanson was a known raider, and when the company announced its sub- stantial holding in ICI, commentators asked when, not if, Hanson would attempt to take over the chemical giant.

The ICI demerger pre-empted the possible bid Hanson, had he taken over ICI, would almost certainly have completed a similar break-up The fact that ICI restruc- tured on its own volition made the company a far less tempting target, since the company was able to realize the kinds of values that a raider would look to achieve Thus, the threat of takeover forced ICI to split itself into two smaller, leaner, more competitive companies.

Not that Hanson Industries applauded the demerger As Lord White, Hanson’s chairman said: “If ICI had not spent so much time during the last year fighting a bid that was never made and spent it on seeing how it could improve shareholder value it might have come up with a better ,

solution a lot earlier.” 14

(See also the Sears case study.)

Lords Hanson and White were the bearers of the new wisdom Even the largest and richest of corporations needs to assess its position constantly and to make whateverchanges are necessary to be competitive The basis of a corporation’s existence is wealthmaximization – this is its reason for being There is no such thing as a “good” corpora-tion that is not competitively profitable Corporations live in a world where the marketdetermines what people will buy and what they will pay A corporation that does notproduce goods that people want at a price they are willing to pay has no reason to exist.

THE CORPORATION IN SOCIETY

Before we evaluate the effectiveness of the major players in corporate governance, weshould look at corporations from the perspective of what our society wants and needsfrom them We want jobs that pay a decent wage and goods and services that meet ourneeds We want challenges to our creativity and ingenuity, and when we meet those challenges, we want to feel proud of the results, and we want to be rewarded We wantcorporations to work with us to keep the workplace and the environment safe We want

a continual sense of progress and growth from our corporations We want our interest

in the company – whether as employee, shareholder, customer, supplier, creditor, or neighbor – to be designed for the long term

Two connected sets of laws govern the relationships of these constituent groups to thecorporation One is comprised of the laws imposed by the legislature and the other is private law established in agreements between the corporation and its employees, customers,suppliers, investors, and community Ideally, the public laws would exist only as a kind

of floor or backstop to establish minimum standards, permitting maximum flexibility forthe corporation and its constituents to devise optimal arrangements between them In otherwords, the government should step in only when the system of corporate governance cannot be assured of producing a result that is beneficial to society as a whole To go back

to our original criteria for determining who is in the best position to make a particulardecision, the government should set the standards when it has better information and fewerconflicts of interest than any (or all) of the other parties who play a role in setting thecourse for the corporation

In practice, however, corporations have influenced government at least as much as ernment has influenced business The corporate “citizen,” with the right to political speech(and political contributions) has had a powerful impact on the laws that affect it In theory,corporations support the free market, with as little interference from government as pos-sible In reality, whenever corporations can persuade the government to protect them fromthe free market, by legislating barriers to competition or limiting their liability, they do so

gov-People of the same trade seldom meet together but the conversation ends in a

conspiracy against the public, or in some diversion to raise prices Adam Smith

To the extent that corporate governance standards are established by public law, one couldargue that these provisions’ greatest value is in providing the illusion of accountability For example, an article written by two thoughtful observers of corporate governance, one

a law professor, one a judge, points to mandatory corporate governance provisions to

support their argument that these rules provide a solid foundation for real (and informed)freedom of choice for investors The rules that inspire this confidence are:

States almost uniformly forbid perpetual directorships; they set quorum rules, which typically require a third of the board and sometimes half of the investors to participate

on critical decisions; they require “major” transactions to be presented to the board sionally shareholders too) rather than stand approved by managers or a committee; theyforbid the sale of votes divorced from the investment interest and the accumulation ofvotes in a corporate treasury; they require managers to live up to a duty of loyalty toinvestors Federal law requires firms to reveal certain things when they issue securities,and public firms to make annual disclosures.15

(occa-The authors go on to acknowledge that, “Determined investors and managers can get ‘round’

Throughout this book, there are examples of getting “round” these rules It does not mean much to “forbid perpetualdirectorships” if management continues to re-nominate the same people The General Motorscase study reveals that the GM board, in the middle of the company’s troubles in 1992,had one member who had been on the board for 20 years, and two who had served for

15 Requiring the approval of a third of the board or half the shareholders does not meanmuch if the board is entirely selected by and beholden to management, and the share-holders do not have the ability to overcome the obstacle of collective choice to makeinformed decisions (See chapters 2 and 3 for further discussion of these issues, as well

as the “duty of loyalty”, the one-share, one-vote issue, and the relevance of required disclosures.)

Many of the laws that govern corporations are designed to make it possible for them

to externalize their costs These laws vary tremendously from state to state and country

to country The tendency for states to try to outdo each other in accommodating business has been called a “race to the bottom” competition because of the way that thestates compete for corporate chartering business through increasingly diluted provisions

In the US, most corporations that operate nationwide or even worldwideare incorporated in Delaware, famous for its extensive and management-friendly laws and judicial decisions governing corporations Globalization may expand the “race to thebottom,” resulting in most of the world’s major corporations incorporating in the worldequivalent of Delaware, perhaps the Cayman Islands Or, if providers of capital are able

to communicate their concerns by directing their funds to enterprises governed by moreinvestor-friendly laws, competition for capital could turn the race to the bottom into arace to the top

The marketplace

Corporations also operate under the laws of the marketplace While these laws can beinfluenced to some extent by the legislature, the marketplace is the ultimate arbiter of corporate performance No matter where a company is located and what it produces, theselaws affect, even determine, every decision made by its directors and officers We wouldcall this the law of economics, if we could use that term without then limiting ourselves

to the narrow vocabulary and assumptions of that academic specialty, so we will just callthem the laws of capitalism

This set of laws reacts to and influences the first set When a company changes its state

of incorporation for tax reasons, for example, that is a function of economics So too is a

company’s consideration of the differing social laws of states and nations, such as varyingregulations governing occupational safety and environmental standards Like a consumerselecting a car, the corporation’s choice of domicile is based on an evaluation of the costsand benefits of all of the options The same kind of evaluation applies to decisions aboutwhether to invest in research and development or whether to update a local factory (orretrain local workers) versus reducing costs by moving the operation abroad.

FUTURE DIRECTIONS

As corporations expand their operations and markets into virtually all parts of the world,

we must begin to develop a more consistent and coherent approach In order to do that, we must, whenever possible, integrate the most important legislated standards withthe realities of the economic laws, so that all incentives promote the five overall goals outlined above, or at least so that they do not conflict with them The law should be process-oriented, not substantive Its focus should be the relationships between the corporation and its constituents, to reduce conflicts of interests (agency costs) and makesure that the right people are making the decisions (or at least are able to monitor theresults of the decisions) that affect them most

One of the problems that is presented by this task is finding some way to balance theneed for long-term planning with the need for present-day assurances that whatever isplanned for the long term is indeed likely to happen Corporations must have as their primary and overriding goal the generation of long-term value A commitment to the satisfaction of employees, suppliers, customers, and the community is essential for achiev-ing this goal But calibrating that commitment to achieve maximum value in the longterm is a daunting task No one can predict the future In the last decade alone we haveseen both new and long-established corporations achieve market dominance and extra-ordinary growth and vitality, only to fall into disaster, sometimes beyond recovery How

do we know that today’s commitment to a long-term research and development project

is going to produce a Dell instead of an Atari? More important, how can our laws best

be designed to increase the likelihood that it will be the former instead of the latter?The World Bank has an extensive governance program for developing economies that the established economies would do well to follow Instead of prescriptive structures,the World Bank encourages countries to develop their own systems that meet three keygoals: transparency, independent oversight, and accountability The Global CorporateGovernance Forum (<http://www.gcgf.org/>), co-sponsored by the World Bank and the OECD, is a new international initiative which will bring together the leading bodiesengaged with governance reform worldwide: multilateral banks active in developingcountries and transition economies, international organizations, country groupingsengaged with governance reform, alongside professional standard-setting bodies and theprivate sector

The Forum has been established to provide assistance to developing transition economies

on corporate governance It has three functions: to broaden the dialogue on corporategovernance; to exchange experience and good practice; and to coordinate activities andidentify and fill gaps in the provision of technical assistance

Through other international efforts, from the International Accounting Standards Board

to the International Corporate Governance Network, global corporations and investorsare working to develop systems that meet the needs of individual cultures and economieswhile making the best possible use of international capital sources

CORPORATE POWER AND CORPORATE PERFORMANCE

We grant legitimacy and authority to the exercise of public (government) power throughaccountability We are willing to defer to the authority of elected officials because we putthem there, and if we do not like what they do we can replace them In the US, thechecks and balances of the three branches of government add to the credibility and legit-imacy of the government Any of the three branches that goes too far can be curbed byone of the others

In theory, the legitimacy and authority of corporate power is also based on ability Corporate governance also has its checks and balances (including the government)

account-In order to maintain legitimacy and credibility, corporate management needs to be ively accountable to some independent, competent, and motivated representative That

effect-is what the board of directors effect-is designed to be

Corporations exercise vast power in a democratic society In a thoughtful and

the various alternative modes for containing corporate power, asking whether and howcorporate power can be “limited or controlled.”

Broadly, there are three alternative possibilities The first is limitation of business powerthrough promoting more competitive markets; the second is broader control of businesspower by agencies external to business; the third, institutionalization within the firm ofresponsibility for the exercise of power Traditionally, we have purported to place majorreliance on the first of these alternatives, in the shape of antitrust policy, without in prac-tice pushing very hard any effort to restrict market power to the maximum feasible extent

I have argued elsewhere that it is in fact possible to move much further than we have

in this direction, without either significant loss in the overall effectiveness of businessperformance or the erection of an elaborate apparatus of control While this, in my judg-ment, remains the most desirable path of policy, I do not in fact consider it the onewhich we will tend to follow To embark on a determined policy of the reduction ofbusiness size and growth in order to limit market power requires a commitment of faith

in the desirability of the outcome and the feasibility of the process which I think is notwidespread What I consider more likely is some mixture of the second and third types

of control.19

Kaysen is pessimistic about the prospects for corporate self-regulation “The development

of mechanisms which will change the internal organization of the corporation, and definemore closely and represent more presently the interest to which corporate managementshould respond and the goals toward which they should strive is yet to begin, if it is to